Highlights of
Report Number: 2007-30-173 to the Internal Revenue Service Commissioner for the
Small Business/Self-Employed Division.

IMPACT ON TAXPAYERS

A
number of taxpayers who have other significant income sources reduce their
taxable incomes by reporting losses on a U.S. Individual Income Tax Return
(Form 1040) Schedule C (Profit or Loss From Business).About 1.5 million taxpayers, many with
significant income from other sources, filed Form 1040 Schedules C showing no
profits, only losses, over 4 consecutive Tax Years (2002 – 2005); 73 percent
were assisted by tax practitioners.By
claiming these losses to reduce their taxable incomes, about 1.2 million of the
1.5 million taxpayers potentially avoided paying $2.8 billion in taxes in Tax
Year 2005.Changes are needed to prevent
taxpayers from continually deducting losses in potential not-for-profit
activities to reduce their tax liabilities.

WHY TIGTA DID THE AUDIT

This
audit was initiated because the Internal Revenue Service (IRS) estimates incorrect
deductions of hobby expenses account for a portion of the overstated
adjustments, deductions, exemptions, and credits that result in about $30
billion per year in unpaid taxes.TIGTA conducted
the audit to determine what actions the IRS is taking to address this potential
noncompliance.

WHAT
TIGTA FOUND

Internal Revenue Code (I.R.C.) Section (§) 183 (Activities not
engaged in for profit), also referred to as the “hobby loss” provision, and
related Treasury Regulation § 1.183-1 do not establish specific criteria for
the IRS to use to determine whether a Schedule C loss is a legitimate business
expense without conducting a full examination of an individual’s books and
records.The purpose of the hobby loss
provision was to limit the ability of wealthy individuals with multiple sources
of income to apply losses incurred in “side-line” diversions to reduce their
overall tax liabilities.Our analysis
showed 332,615 high-income taxpayers received the greatest benefit by potentially avoiding approximately $1.9 billion in taxes for Tax Year 2005.

The
I.R.C. and Treasury Regulation do not require a taxpayer to have a reasonable
expectation of profit; rather, the taxpayer needs just the “objective” of
making a profit.I.R.C. § 183 makes it
difficult for the IRS to efficiently administer tax law that ensures taxpayers
are not deducting not-for-profit losses to reduce their taxes on other incomes
year after year.

WHAT TIGTA RECOMMENDED

TIGTA
recommended the Commissioner, Small Business/Self-Employed Division, provide a
copy of this report to the Department of the Treasury, Office of the Assistant
Secretary for Tax Policy, to consider proposal of legislative changes to I.R.C.
§ 183.The proposal should include
establishing a clearly defined standard or bright-line rule for determining
whether an activity is a business or a not-for-profit activity.Due to the large number of these tax returns
being prepared by tax practitioners, TIGTA also recommended the Director,
Communications, Liaison, and Disclosure, Small Business/Self-Employed Division,
continue to coordinate with practitioner organizations to encourage compliance
with existing provisions.

In
their response to the report, IRS officials stated they agreed with the
recommendations and plan to take appropriate corrective actions.The Director, Communications, Liaison, and
Disclosure, Small Business/Self-Employed Division, plans to coordinate with the
Office of Legislative Affairs to forward a copy of the final report to the
Department of the Treasury Office of Tax Policy and to include key messages and
talking points about I.R.C. § 183 tax obligations as a Fiscal Year 2008
outreach initiative directed to practitioner organizations.

READ THE
FULL REPORT

To view the report,
including the scope, methodology, and full IRS response, go to: